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Financial Literacy: an Essential Tool for Informed Consumer Choice?

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Financial Literacy: an Essential Tool for Informed Consumer Choice? NBER WORKING PAPER SERIES FINANCIAL LITERACY: AN ESSENTIAL TOOL FOR INFORMED CONSUMER CHOICE? Annamaria Lusardi Working Paper 14084 http://www.nber.org/papers/w14084 NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 June 2008 I would like to thank Keith Ernst, Howell Jackson, Kevin Rhein, Peter Tufano, and participants to the conference "Understanding Consumer Credit: A National Symposium on Expanding Access, Informing Choices, and Protecting Consumers," Harvard Business School, November 2007, and the conference "Consumer Information and the Mortgage Market," Federal Trade Commission, Washington, D.C., May 2008 for suggestions and comments. This paper builds on several projects I have written in collaboration with Olivia Mitchell, whom I would like to thank for her encouragement, support, and many suggestions. Audrey Brown provided excellent research assistance. Any errors are my responsibility. This paper was written while visiting Harvard Business School and I would like to thank them, and in particular Peter Tufano, for their hospitality. The views expressed herein are those of the author(s) and do not necessarily reflect the views of the National Bureau of Economic Research. NBER working papers are circulated for discussion and comment purposes. They have not been peer- reviewed or been subject to the review by the NBER Board of Directors that accompanies official NBER publications. © 2008 by Annamaria Lusardi. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source. Financial Literacy: An Essential Tool for Informed Consumer Choice? Annamaria Lusardi NBER Working Paper No. 14084 June 2008 JEL No. D14 ABSTRACT Increasingly, individuals are in charge of their own financial security and are confronted with ever more complex financial instruments. However, there is evidence that many individuals are not well-equipped to make sound saving decisions. This paper demonstrates widespread financial illiteracy among the U.S. population, particularly among specific demographic groups. Those with low education, women, African-Americans, and Hispanics display particularly low levels of literacy. Financial literacy impacts financial decision-making. Failure to plan for retirement, lack of participation in the stock market, and poor borrowing behavior can all be linked to ignorance of basic financial concepts. While financial education programs can result in improved saving behavior and financial decision-making, much can be done to improve these programs' effectiveness. Annamaria Lusardi Harvard Business School Morgan Hall , T93 Boston, MA 02163 and NBER [email protected] Introduction Over the past thirty years, individuals have had to become increasingly responsible for their own financial security following retirement. The shift from defined benefit (DB) to defined contribution (DC) plans has meant that workers today have to decide both how much they need to save for retirement and how to allocate pension wealth. Furthermore, financial instruments have become increasingly complex and individuals are presented with new and ever-more- sophisticated financial products. Access to credit is easier than ever before and opportunities to borrow are plentiful. But are individuals well equipped to make financial decisions. In other words, do they possess adequate financial literacy to do so? This paper shows that most individuals cannot perform simple economic calculations and lack knowledge of basic financial concepts, such as the working of interest compounding, the difference between nominal and real values, and the basics of risk diversification. Knowledge of more complex concepts, such as the difference between bonds and stocks, the working of mutual funds, and basic asset pricing is even scarcer. Illiteracy is widespread among the general population and particularly acute among specific demographic groups, such as women, African- Americans, Hispanics, and those with low educational attainment. Financial literacy affects financial decision-making; ignorance about basic financial concepts can be linked to lack of retirement planning, lack of participation in the stock market, and poor borrowing behavior. Several initiatives have been undertaken to foster saving and financial security. The evidence is, in some cases, mixed, but several programs have proven effective in fostering saving and increasing participation in pension plans. However, much more can be done to improve the effectiveness of these programs. Furthermore, initiatives should 2 consider a wider spectrum of financial behavior; for example not only saving, asset allocation, and pension but also borrowing behavior. Theoretical Framework The theoretical framework used to model consumption/saving decisions posits that rational and foresighted consumers derive utility from consumption over their lifetime. In the simplest format, the consumer has a lifetime expected utility, which is the expected value of the sum of per-period utility discounted to the present from the consumer’s current age to his/her oldest attainable age. Assets and consumption each period are determined endogenously by maximizing this utility function subject to an intertemporal budget constraint, which represents the present discounted value of future resources (which include earnings, Social Security, and pensions). This model posits that the consumer holds expectations regarding discount rates, investment returns, earnings, pension and Social Security benefits, and inflation. Further, it posits that the consumer uses that information to formulate and execute optimal consumption/saving plans. In other words, the consumer looks ahead and plans for the future taking his/her lifetime resources into account. Even in this basic formulation of the saving decision, the actual requirements for making saving decisions are demanding: Individuals have to collect information and make forecasts about many variables, from Social Security and pensions to interest rates and projected inflation, to name just a few. Moreover, they have to perform calculations that require, at minimum, an understanding of compound interest and the time value of money. Decisions about how much to accumulate and how much to borrow to be able to smooth consumption over the life-cycle also require an understanding of the working of interest rates. 3 Do individuals possess the level of financial knowledge and numeracy necessary to perform the calculations mentioned above? Does saving and borrowing behavior follow the predictions of these simple models? While financial literacy has often been overlooked in previous studies, it can be an important predictor of financial behavior. The next section provides an examination of the level of literacy individuals possess. Basic and Advanced Financial Literacy Basic Financial Literacy Several surveys exist that report information on financial knowledge in sub-groups or among the whole U.S. population.2 However, these surveys rarely provide information on variables related to economic outcomes such as saving, borrowing, or retirement planning. In an effort to combine data on financial literacy with data on financial behavior, Lusardi and Mitchell (2006) have pioneered inserting questions measuring financial literacy into major U.S. surveys. They first designed a special module on financial literacy for the 2004 Health and Retirement Study (HRS); this module has now been added to the National Longitudinal Survey of Youth (NLSY). These and other questions measuring financial knowledge have also been added to the Rand American Life Panel (ALP) and to other surveys covering specific sub-groups of the population.3 The addition of these types of questions to existing surveys not only allows researchers to evaluate levels of financial knowledge but, most importantly, makes it possible to link financial literacy to a rich set of information about household financial behavior. 2 See Lusardi and Mitchell (2007b) for an overview of these surveys. 3 These questions have been added to a survey of participants to the state employees plan in the state of Nebraska (Medill 2007). Moreover, they have been added to the 2005 Dutch DNB Household Survey (van Rooij, Lusardi and Alessie 2007), the 2006 Italian Household Survey on Income and Wealth, a 2007 pilot survey of participants in Mexico’s privatized Social Security plan (Hastings 2007), and a survey on entrepreneurs in Sri Lanka (de Mel, McKenzie and Woodruff 2008) 4 Given the limited number of questions that can effectively be added to surveys, researchers have to assess financial literacy from only a handful of questions. But which questions should be asked to determine whether respondents possess financial literacy? Moreover, which data allow researchers to most accurately assess the effect of literacy on behavior? As will be reported below, it is possible to gauge financial knowledge from a small set of questions. The three questions Lusardi and Mitchell (2006) devised for the HRS measure basic but fundamental concepts relating to financial literacy, such as the working of interest rates, the effects of inflation, and the concept of risk diversification. The questions are as follows: 1) Suppose you had $100 in a savings account and the interest rate was 2% per year. After 5 years, how much do you think you would have in the account if you left the money to grow: more than $102, exactly $102, less than
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